The Negative Income Tax and Work Incentives

This post is the second in a series on the negative income tax. The first installment can be found here.

Perhaps the most common criticism of the negative income tax (NIT) concerns its effect on employment incentives. Since individuals receive a guaranteed basic income (GBI) under the NIT, opponents argue that they do not face pressures to work that currently exist and will, consequently, work less.

But is it true that the NIT discourages employment?

Of course.  Economic theory postulates that taxing employment encourages rational actors to work less (especially in a progressive tax system like Canada’s, where high-income earners contribute the most tax revenues). Furthermore, as long as “leisure” remains a normal good–which individuals consume in larger amounts as their incomes rise–there is a chance that individuals will respond to the NIT by adjusting the balance between leisure and labour in the former’s favor.

But this reasoning suggests that higher taxes and generous welfare provisions create a similar employment effect. Despite this, these policies remain popular because of the widespread belief that it is possible and good to sacrifice economic activity for equity’s sake.

Given this understanding of taxation and its effect on employment, it is clear that any policy, whether demand-side or supply-side, generates differing incentives and disincentives. It is more important to question the severity of these effects and whether or not they cause real harm.

Policymakers must balance these effects when designing welfare programs. In order for policies to target low-income individuals, benefits must decline at some point as income rises. Some conventional welfare systems, for example, offer both a GBI and a benefit that supplements earned-income until it equals a certain amount. Because these programs subsidize those who work less by supplementing their income, they discourage individuals from earning more than the minimum income level. This indemnifies individuals to what economists refer to as a “welfare trap,” whereby the individuals cannot increase their income by working more, since the government gives them less when they earn more. There are also systems that require welfare recipients to be unemployed, encouraging them to sacrifice employment in exchange for government benefits.

Recognizing that targeted welfare programs reinforce the poverty of those targeted, proponents of the NIT favour a system in which individuals from all income brackets, independent of employment status, receive a basic income and a flat tax rate applies to any additional income earned beyond this level. This allows individuals to increase their income (and to not risk losing benefits) by working more.

Furthermore, the disincentives associated with the NIT are not necessarily harmful to the economy. Individuals who withdraw from the labour force, for instance, improve employment prospects for those who choose to work by reducing competition in the labour market. This could also boost wages for those who remain employed.

Ultimately, the NIT stands to alter beneficially work disincentives that already exist. It does so by replacing targeted welfare programmes with a single universal benefit that improves individuals’ ability to work and increase their incomes provided they want to do so. For those who cannot or chose not to work, it provides a basic income that meets prevalent equity expectations.

However, the NIT’s success in changing labour markets as I have described is contingent on existing programmes coming to an end.  Next week, I will consider particular policies that the NIT would make unnecessary and how it could reduce government bureaucracy.

Michael Sullivan is a 2013-2014 Atlantic Institute for Market Studies’ Student Fellow. The views expressed are the opinion of the author and not necessarily the Institute

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